When I was growing up in the 1980s, we had a mortgage with an interest rate of around 16%. A sudden rise in rates from about 1984 caught my family by surprise. Money became tight, and there wasn’t even enough left over for an ice cream on the weekend.
If you want a clear idea on where interest rates and vis-à-vis asset prices could go, it pays to consider inflation.
Right now, it seems that the CPI may not be measuring the true rate of inflation. Here in New Zealand, 2020 saw house prices increase by 19%. Rents increased 3.1% between December 2019 and December 2020. I estimate the car I purchased just prior to Covid-19 would now cost up to 15% more.
While the CPI basket does include some housing costs — in particular, rentals and ‘newly constructed dwellings (excluding land)’ — it would appear that these are insufficiently weighted. Or the omission of second-hand dwellings and land means that real inflation is never properly considered at a policy level.
‘Purchase of second-hand motor cars’ is included, and shortages following Covid may well impact the next CPI measure.
But the real concern is that you have inflation largely being measured without considering the overall residential housing market. And with that market being such an important driver of the economy, real inflation is effectively ignored.
What are the consequences of ignoring house price inflation?
We are already seeing this. Severely unaffordable home prices across the country. Fear of missing out. And the mortgage brokers we speak to are routinely writing loans of $900,000 or more, with debt-to-income levels often above 5x.
In other words, inflated home prices are supported by more and more debt. And they rely on existing prices in the market — since people often leverage on existing equity, or sell a property to buy another property.
The recent announcement on LVRs may not help much.
A 40% deposit for rent-to-buy investors sounds a lot on the surface. But most of these investors will already have a family home. Banks are always happy to lend on the security of a family home, since that is usually the last thing people will want to default on. So, many investors could easily tap the 40% required by leveraging on their other equity.
Yet there are a few ways we could restore home affordability:
1) Dramatically increase supply
Especially at the key entry point of the market — which are rental houses. If this can be done, rents would fall. More and more landlords would sell their houses. You’d see a cascade affect into affordability.
Of course, the problem is that we don’t currently have the capacity to build homes on the scale required. That would need a concerted effort from central government.
2) Restrict debt by tax deductibility
One of the main reasons property investment is so attractive is that leverage is incentivised by the tax system. An investor’s mortgage interest is usually fully tax deductible.
This seems logical as the interest is a cost in allowing the investor to generate rental income.
But what if that was not allowed? In many tax jurisdictions — such as the UK, for example — only part of the interest cost can be offset against rental income.
Again, such measures could push more marginal landlords to sell, thereby reducing prices.
3) Restrict debt by income
Right now, there doesn’t appear to be any mandated restrictions on DTI (debt-to-income) for most borrowers. Even some mortgage brokers tell me they are concerned about the levels they see. Particularly with an eye to the economic impacts this will have — less money going back into the local economy, more going to offshore banks.
In Britain, most home mortgages have DTIs restricted to 4.5x — your debt cannot be more than 4.5x your annual income. In Ireland this is restricted even further to 3.5x.
Home prices in both Britain and Ireland are more affordable than in New Zealand. An average property in the UK (November 2020) sits at £249,633 ($476,799). In Ireland, (Q4 2020) the average was €269,522 ($452,797). Here in NZ, the average home price (December 2020) was $788,967.
Why are home prices 70% more in this country than in the UK and Ireland? It is warmer, the food is likely better, and the houses are larger. But that is changing fast with intensification. And many New Zealand homes are more exposed to natural risks such as earthquake or volcano.
Debt appears a much greater fuel to bubble prices than in Europe.
Yet the price of debt remains a threat
If inflation is growing and not being clearly measured — by definition, that is distorting the economy. The longer such situation is left, the more damaging it can be. Then interest rates need to rise more quickly to deal with the full extent of the problem.
Long-term treasury bond yields already look to be moving upward. So if you look out to 5-year fixed mortgage rates, these are currently around 4%.
The reopening of the global economy is also likely to be stimulatory and inflationary. Which will put ongoing pressure on wholesale lending rates.
A good sign of this — and one that investors may like to consider — is the recent rises in bank stock prices. It could be a good time to look at cyclicals like bank, insurance, and asset-management companies that can benefit from rising rates and changing risk sentiment. We cover views on the best opportunities in our premium research.
In this way, investors could capture the upside of a debt bubble, without being overexposed to it in leveraged housing.
For now, the government seems to have housing in its sights. We cannot go on with not enough houses for our people. And crazy prices.
The tide is starting to turn, but it may need more of a breakwater.
We have researched a plan too. One that is bold but very doable.
I encourage you to check that out and sign our petition at this website
Editor, Wealth Morning